Page 92 - Annual Report 2023

23 BANKA KOMBËTARE TREGTARE
Notes to the Consolidated Financial Statements for the year ended 31 December 2023
(amounts in USD, unless otherwise stated)

The weighted average incremental borrowing rate applied to lease liabilities recognised under IFRS 16 was 2.59%. The incremental
borrowing rate is determined as the base rate yield curve plus the credit spread.

a. Base rate yield curve
Input data in the model are money market rates (inter-bank rates in maturity bucket ON-10Y). These data are published on daily basis
in “Reuters” (inter-bank trading platform). For higher maturities, the rate is calculated by extrapolating starting from the money market
rates of initial application date.

The Bank uses the Nelson-Siegel-Svensson model for extrapolation purposes for USD yield curve construction, which fits an exponential
approximation of the discount rate function directly to market prices. The Bank introduced the application of the augmented NSS
(Nelson-Siegel-Svensson) model as a version that has the ability to combine different forms of graphs, allowing in essence negative
rates as well as atypical interest rate distributions, which are not captured accurately by the classic Nelson-Siegel model.

The Bank uses the Cubic spline interpolation for EUR yield curve construction. Cubic spline interpolation is a special case of spline type
interpolation that is used very often to avoid the problem of Runge’s phenomenon. This method gives an interpolating polynomial that
is smoother and has smaller error than some other interpolating polynomials such as Lagrange polynomial and Newton polynomial.
Cubic smoothing splines fitted to univariate time series data can be used to obtain local linear forecasts. The approach is based on a
stochastic state space model which allows the use of a likelihood approach for estimating the smoothing parameter, and which enables
easy construction of prediction intervals. In essence the same mathematical mechanic is followed by the NSS (Nelson-Siegel-Svensson)
model. Whereas an interpolation typically begins with specifying a functional form either to approximate discount function or forward
rates, and then estimates the unknown parameters. The cubic spline approach, brings more flexibility on the shape of a yield curve
and is thus good for financial practitioners who are looking for small pricing anomalies.

To construct local currency, Albanian Lek (ALL), yield curve (YC) the Bank is using the Cubic spline interpolation, as described above.
Yields of government bonds (ON-1Y) are auction results published by Ministry of Finance and Bank of Albania at the end of each
respective auction. For auctions that are not so frequent, the rate is calculated by extrapolating between rate values of the last 2Y bond
and the rate derived from the last auction of the bond in question. The issue encountered by the bank’s forecasts on Treasury Yields
is of the Runge’s phenomenon type, which is a problem of oscillation at the edges of an interval that occurs when using polynomial
interpolation with polynomials of high degree over a set of equispaced interpolation points.

b. Credit spread
For the credit spread calculations, the Bank has approached the following logic:
1) Identify the international long-term Issuer Default Rating of the financial institution (“Bank”). International long-term IDR is given by the
External Credit Rating Agency such as Moody’s, Fitch or Standard & Poor. The Bank will use only the official, world-wide accepted,
external credit rating agencies such as Fitch, Moody’s and S&P because only these 3 agencies do the analyses world-wide, make
and publish the studies on PDs, LGD’s (where credit spread will be determined as PD*LGD) etc. on the global level. These three
agencies are also the only ones allowed to be used for the purpose of relying on the expert-data parameters for e.g. in EU (as per
CRD/CRR regulation etc.).
2) If the financial institution (Bank) does not have such a rating and it is part of a Group, the lower rating of the country ceiling for the
country where Bank is located and the external agency’s international long-term Issuer Default Rating of the ultimate parent is used.
The underlying reason for this approach is that when a bank is part of a group, support is more likely.
3) If neither of these steps results in a rating, country ceiling for the country in which Bank is located is identified and at least one notch
is subtracted. The country ceiling is the best rating that an entity based in that country can receive, so this is used as a benchmark
as we tend to work with the biggest and most robust institutions. Additionally, the downward risk adjustment is made for the sake
of prudence.